Risk Management

Max Risk Per Trade

The probability of tossing 8 tails in a row is (1/2)⁸ = 1 in 256. Then a sequence of 256 trades is likely to contain a string of 8 losing trades. If you risk 2% of your account on each trade, the drawdown would be 15%. If you risk 10% on each trade, the drawdown would be 57%.

Never risk more than 2% of your account on any trade.

A risk of 1% to 2% of account per trade is appropriate.

If we have Multiple Positions open at the same time, the positions should be uncorrelated. If they are correlated, (GM and Ford would be usually correlated) they should be logically combined into one larger position for risk management purposed.

Account Size

For Swing Trading Stocks, ETFs, and Options start with at least $10,000.

We arrive at is number by observing that if the max risk for a trade (stop loss) is $200, this is 2% of a $10,000 account.

Note: for forex swing trading start with as little as $2,000.
For futures swing trading, start with $20,000+.

Risk / Reward Ratio

This is the ratio of the Maximum Risk to the Expected Reward for a given trade or for a given strategy, where risk and reward are measured in dollars. We will refer to it as the RR Ratio.

It is important to note that the RR ratio by itself is not useful. We must also know the probable Win Ratio for to RR ratio to be useful.

We note that Expected P/L = Reward * Win Ratio – Risk * (1 – Win Ratio).

Typical RR ratios might be 1/1, 2/3, 1/2, and 1/3.
Typical Win Ratios might be .20, .30, .40, .50, .60, .70, and .80.

The following table gives the Expected P/L for the different combinations of these values when the risk in each case is $100.

Stop Loss & Profit Target

Before any trade is entered it is critical that both a Stop Loss and a Profit Target have been established.

For risk management is is imperative that a Stop Loss must always be in place for all positions, and it is imperative that the Stop Loss must always be honored.

We note that Risk per share = Entry Price – Stop Loss Price and therefore and we need to know the Stop Loss amount before we set the Position Size for a trade.

Obviously the Risk / Reward ratio = (Entry Price – Stop Loss Price) / (Target Price – Entry Price).

How to set the Stop Loss and Profit Target price depends on the Strategy.

• For some trades the Stop Loss amount my be a multiple of ATR.
• For some trades we may set our stop near a Support or Resistance level or near a Trend Line or a Moving Average.
• The stop loss may be based on a percentage.
• For Chart Patterns we may set a stop near the low of the pattern and set a profit target based on a measure rule.
• There are many other ways to set the stop loss for example Swing Traders often employ a multiple-day high/low method, in which stops are placed at the low price of a predetermined day’s trading. For example, lows may consistently be replaced at the two-day low. More patient traders may use indicator stops based on larger trend analysis. Indicator stops are often coupled with other technical indicators such as the relative strength index (RSI).
• Note that a trailing stop loss may also be used by some strategies and that some strategies specify when to move the stop up.
• See each individual strategy for the rules for setting the Stop Loss and Profit Target.

Problems with stop loss orders:

• Stop Loss orders don’t work well for large blocks of stock.
• They do no execute during extended hours (pre-market and after market).
• They do not protect against large over night gaps up or down.

Options (buying puts or calls) can be used to afford protection from large gaps but:

• They cost money.
• Most contracts are for 100 shares and you cannot excercise partial.

Position Sizing

Position sizing reduces your risk by diversifying your risk over more than one instrument.

How much we diversify depends on the trading time frame for a give style of trading.

A swing trader can manage two to four open positions:

• 40% each for two positions & 20% cash
• 30% each for three positions & 10% cash
• 20% each for four positions & 20% cash.
• ========
• Margin: Do not use margin until you have confidence based on a track record of sucessful trading.

[Note: a day trader might only want to have one position open at a time and by using tight stops can control risk while using 4 to 1 leverage. A long term investor should be much more diversified that either of the above.]

In addition to the above, we must also look a the particulars of the trade itself. The trade may specify that the stop loss should be placed Stop dollars below the entry point. Stop * position quantity = amount risked and must be < 2% of account. So the Position Quantity must be < 2% of Account / Stop.

For example, if Account = $10,000 and we are trading 2 positions and Price =$100 and Stop = $4.:
1) 40% of $10,000 = $4000. Position Quantity = $4000 / $100 = 40 shares.
2) Position Quantity must be < 2% of $10,000 / $4 = 50 shares.
So we could buy 40 shares.

We note that, in terms of risk management, since you Stop Loss represents your Risk, that the Position Size and Stop Loss amount are intimately related and we need to know the Stop Loss amount before we set the Position Size.

Also we note again that if we have Multiple Positions open at the same time, the positions should be uncorrelated. If they are correlated, (GM and Ford would be usually correlated) they should be logically combined into one larger position for risk management purposed.